Investors want intense scrutiny before they invest in startups

While due diligence was always part of the protocol for many investors, in the past they would often limit the scope or chose to ignore the concerns raised around future growth predictions.Sachin Dave | ET Bureau | April 04, 2016, 16:29 IST

In what could just be an indication of what lies ahead for start-ups, investors are stepping up scrutiny before they put in their money, especially in the second round of funding, and are getting a thorough due diligence done.

In the past three to six months, investors -- including private equity, venture capitalists and strategic investors -- have been treading carefully.

While due diligence was always part of the protocol for many investors, they would often limit the scope or chose to ignore the concerns raised around future growth predictions. However, that is now changing, say industry experts.

Not only the investors want a proper due diligence conducted, looking into every aspect of the startup, many of them are also shelving their investment plans, say experts.

“Increasingly, we have seen that many private equity as well as strategic investors are getting the due diligence done before they invest in a start-up. And in certain cases, we have also observed that investors tend to re-evaluate their investment decisions, especially after the due diligence,” said Atul Mehta, Partner in the transaction advisory services, EY.

The deals are being thoroughly looked at and in some cases shelved in startups where at least one round of funding (series A) is already done.

Earlier, many investors would just go ahead with a deal if there’s already an investor. “It would be assumed that the first investor must have done his diligence. Also, there was euphoria around some start-ups or certain business models that has changed,” said an India head of a large private equity firm that has invested in some startups.

In the last three months, investors have shelved deals not just in some known start-ups but also in the so-called unicorns after due diligence reports indicated concerns, say people in the know.

“As the investment environment gets tough, many investors are taking a cautious take before they commit an investment in a start-up. Investors are closely looking at the numbers, especially in the second round of funding,” said Sanjeev Krishan, leader private equity practice, PwC India.

Industry trackers say that the sudden concerns are also being raised around the high valuation of some of the biggest players, including the unicorns. In February this year, Morgen Stanley Institutional Fund Trust marked down its 27% stake in Flipkart.

The resetting of valuation in Flipkart has also seen many investors looking at the start-up space with caution, say industry trackers. Investors have started asking tough questions around the valuations and the revenue models.

And for some of the start-ups, especially in the online market place space, tough times could be ahead. “The recent government announcement to allow 100% foreign direct investment (FDI) in ecommerce could also mean that some investors would re-look at the impact and their exit strategies in some of the Indian start-ups before they commit their funds,” said a fund manager.